A Walk Down Memory Lane... or... Psychological Hedging

petershk · Mar 10, 2015

Hi Guys.
I've been kicking around the idea of FIREing soon (1-2 years). Financially it all looks so nice and rosy... having gone through 2 crises (I was in tech in 2001, I was lucky to not own a house in 2008) I have seen and felt how crushing that can be. I also am aware of how when things are good we underestimate how we will feel when things are bad (I think it's called the empathy gap)... and the reverse. So to try and guide how I should allocate assets (specifically how much cash to have lying around unproductively), I went back in time and read some of the posts here from Sept-Dec 2008. Thought I'd share... it was really enlightening and helpful as we are now debating how high on the rollercoaster we are and how far down and long the dip may or may not be. All things we KNOW are essentially impossible to predict, but we will also engage in wish fulfillment after the fact... as you can read below

Sunset · Mar 10, 2015

Oh the memories, it was scary times !
I was working, so that was good, but I feared I would lose my job, so I built up a cash stash and after that started buying stocks.

Now, reading those entries, reminds me how it will be even more terrifying when retired. Cemented my view to build up my cash stash for a while, no more stock buying, let the dividends accumulate for the big drop.

petershk · Mar 10, 2015

Sunset said:
Oh the memories, it was scary times !
I was working, so that was good, but I feared I would lose my job, so I built up a cash stash and after that started buying stocks.

Now, reading those entries, reminds me how it will be even more terrifying when retired. Cemented my view to build up my cash stash for a while, no more stock buying, let the dividends accumulate for the big drop.

Yes exactly.

The reason I'm looking is because I'm trying to evaluate my own "empathy gap." On paper, rational human beings should not care about market fluctuations like that.

We've all used Firecalc, and it tells us even in the WORST historical record (Which now includes 2008/9) we're fine if we just hold the course, keep taking withdrawals and ignore it.

..and yet...

those threads are full of rational people thinking about selling low, going back to work, etc.

Something I noticed is that most of the people who seem to weather it well either:
1) have insane resistance levels
2) have enough cash that they "don't have to sell for x years"
3) have cash in the wings "waiting" for that correction

It seems like the biggest factor people underestimate is how they will react to a BIG RED NUMBER in their account. You see that and you start thinking "****. What if this gets EVEN WORSE?" "What if it takes 15 or 20 years to come back?" "What if it goes to 0?"

Of course, all those things CAN happen... but they didn't.

I am sure that during the next big downturn we will react exactly the same way.

So I think what I'm going to do (because I am not psychologically strong like some of you) is keep about 2 years of cash + 1 year for "reinvesting" when something crashes. I realize this is suboptimal asset allocation, but I consider it insurance against my future self being stupid.

If the market drops 20 or 30 or 40%, I don't have to sell (Draw cash) AND I'll be able to invest at "lows" thus taking advantage of the psychological rush of (a) buying low and (b) feeling smart.

But man I wish I was just more resilient.

audreyh1 · Mar 10, 2015

Don't let someone tell you that's "suboptimal asset allocation". The whole point of diversification is to invest across multiple asset classes so that when one tanks, others don't tank or tank less, or even appreciate. One picks their asset allocation to achieve a certain long-term performance versus short-term volatility trade off. One is deliberately choosing a trade off. So criticizing someone who uses asset allocation for not maximizing their long-term growth potential makes no sense. Someone who truly wishes to "optimize" their long term return had better be 100% small company stocks.

Fixed income (of which cash can be a part) isn't only there to generate income. I ignore that aspect entirely as I am a total return investor. It's there to counterbalance the equities and reduce the volatility of the portfolio, which also means that when equities drop hard you have something to sell to buy more equities.

audreyh1 · Mar 10, 2015

BTW - that was a remarkable walk down memory lane. I encourage you to read the 2009 (after March) and 2010 threads as we experienced a remarkable recovery.

utrecht · Mar 10, 2015

I looked back at several of those old doomsday threads and it seems to me that almost all of them are started by relative newbies to the forum and most comments by regulars are along the lines of "hang in there" and "stay the course".

Dd852 · Mar 10, 2015

I agree with these sentiments completely. I'm not about maximising return - I'm about maximising my happiness and peace of mind! We currently have 1.8 years expenses in cash and FI represents another 8.4 years so that's a decade in my pocket - as I'm 55 that gets me within spitting distance of social security. Equities cover another 23 years' worth of expenses so I figure all I need the markets to do is equal inflation over the period and I'm ok. Reducing expenses is of course the next thing that can and will be done in a really big down turn. But to the OP point, am I leaving money on the table by not having a bigger equities exposure? Absolutely. But what I am buying is peace of mind. And as we don't have children, the only real losers from this strategy are the charities that will get the remaining estate, but I'm not trading my peace for their prosperity!

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REWahoo · Mar 10, 2015

utrecht said:
I looked back at several of those old doomsday threads and it seems to me that almost all of them are started by relative newbies to the forum and most comments by regulars are along the lines of "hang in there" and "stay the course".

Did you expect something different?

petershk · Mar 10, 2015

Audrey: great advice. Btw I saw many of your replies in those threads and they are very valuable as are many other regulars here.

When I was in "income saving" mode I kind of ignored the conservative asset allocation people. As I get closer to FIRE I'm singing a different tune. I am starting to see the value in having access to cold hard cash during periods of psychological stress.

Those threads are chock full of great examples of hindsight bias, false regret, empathy gap and all the other things we think happen to others but of course we believe we are immune to.

I can just imagine the hoards of people who sold out near the bottom fearing the end of the world only to miss the subsequent rally when the world didn't end...and they might be buying back in around now (just as the world may look like it may end again.. which of course it probably won't

).

I know Warren Buffett says rule #1 is don't lose money...but I think for the average investor it's "don't do anything stupid." I think I'll optimize for protecting against my own stupidity and offset it by controlling my cost of living.

A drop of 40% in my portfolio, if I have 4 years of cash would only reduce my living expenses by 15% to maintain withdrawal rate. That is MUCH easier to swallow than psychologicay riding out a 100% equity allocation where I'll have to sell at the bottom even if it means in aggregate over 30-40 years it's a few % lower returns. From what I see it's the loss of options that crushes people... Not just the drop in portfolio value. One guy makes a comment that selling everything and then buying something else felt really good because the numbers turn from red to green. This is a very true thing... Easy to laugh at when were riding a nice bull... But totally true when our net worth plummets one a rock.

Are there any good books on "building a psychologically defensive portfolio" or something?

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Andre1969 · Mar 10, 2015

One statement that caught my eye was this: "Some of the people with financial backgrounds probably can guesstimate this one, but I understand that, during the Great Depression starting in 1929, those who left their money in stocks took alllll the way to 1954 to recoup the losses. Please correct me if I am wrong on that statement."

It was in the "Length of time to recover our Money" thread.

I've heard about that before, and it got me a bit curious, so I googled it. I found this article from the New York Times, which gave a little perspective on that. http://www.nytimes.com/2009/04/26/your-money/stocks-and-bonds/26stra.html

While it wasn't until 1954 that the DJIA got back to its 1929 peak, the NY Times said that the typical investor would have been made whole again by 1936, about 4 1/2 years after the bottom was hit in 1932. The main factors were 1) Inflation/deflation, 2) dividends, and 3) the fact that the DJIA is a relatively minor slice of the total economic pie.

In the overall scheme of things, I haven't been investing all that long. I really didn't get serious until early 1998, just before I turned 28. But, since then, there have only been three periods where I suffered a yearly loss.

The first was the 2000-2002 period. I lost a little in 2000, and a lot in 2001-2002, but 2003 took off, and I was probably made whole again in 2004.

The second was the "Great Recession". I peaked in October 2007, hit bottom in November 2008, but was pretty much recovered around May of 2010.

The third was 2011, where the first part of the year was volatile for me, but then peaked around July, with a quick 15% correction by August. The rest of the year pretty much trended back upward, but I finished it with a very slight loss. I was fully recovered by January 2012 though.

I think 2011 was the last time I saw a correction that big, as well. I do remember some turmoil around April/May of 2012, but it didn't last long. And there have been dips since then, but they've usually resolved themselves pretty quickly.

According to that NY Times article, the longest recovery time we've had, since 1900 at least, was during the 1974 oil embargo. The market had peaked in late 1972, bottomed out in late 1974, and it wasn't until late 1982 that the typical investor would have been "made whole". Considering how bad things got in 1974-75, and then the second recession in 1979-82, I guess that's not too bad.

petershk · Mar 10, 2015

Andre: I've researched similar things as well.

The big error I see in those analyses is that they don't present alternatives given the same information.

I mean that... Ok it takes 5 or 10 years to recover... Vs what? Predicting the crash and avoiding it? Ok cool. How does someone do that again

. Of course with survivorship bias SOMEONE will always predict every change in advance... No one does it consistently.

So compared to entering and leaving... Staying in is statistically better. Not perfect and maybe just "less bad." That's why I think a "protect me from stupid" portfolio is what I want to build.

I just don't trust myself during extreme conditions.

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urn2bfree · Mar 10, 2015

The amazing thing to me looking at all of this is that if you truly believe in a SWR, then your initial withdrawal should ok if it is x% of THE HIGHEST VALUE YOUR PORTFOLIO EVER REACHED. (Adjusted for inflation). SWR is the MINIMUM allowed accounting for the worst case scenario we have ever seen -SO FAR in the USA.

That is, let's say you were convinced 3% was an okay SWR. And you were flying high in 2007 with a portfolio of $2 million, planning to retire in 2008 and withdraw $60,000 a year (Adjusted for inflation). But Wham! 2008 comes and your well diversified portfolio shrinks by 40% down to $1.2 Million. According to SWR data - you should be fine taking that $60,000 a year (Adjusted for inflation) and so far it would have been right...since the natural history of our markets so far has been that bad years are followed by amazingly good years....even after the calamities of the 30’s (deflation and sluggish returns) and the 60’s and 70’s (when returns were terrible along with horrible inflation) 4% from the highest value your portfolio ever reached* (Adjusted for inflation) was sustainable for at least 30 years in the overwhelming number of cases.

Now the problem is that this time may be different and the USA has had a good century and a half which may never be repeated. Hence people propose the lower SWR numbers like 2.6% to 3.5%. But nowadays one diversifies around the globe, so to be pessimistic you would have to believe the whole world is going to be worse this time. You are welcome to live in that kind of fearful place, but I choose to take my chances that if the world is that bad a place with me retired, for me it would suck even more if I were still working.

*the reason I reference the highest value your portfolio reached rather than the value the day you actually start withdrawing is that the SWR "works" for those who start withdrawing money at the peak, so how could it not work if you don't start at the peak and therefore have a zero withdrawal that peak year.

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petershk · Mar 10, 2015

Urn2bfree: EXACTLY.

But... What I saw was many threads where people reran firecalc with their new investment amount, saw the success rate hit 85% and panic like mad. They know that statistically this is silly... But when you see your money drop like that and are faced with maybe having to find work while the sky is falling... That is cold comfort.

So if you have 3 years of cash on hand... That's much more likely to allow you to be rational.

As many people in those threads point out. If the market goes to 0 or if it basically dies so much a few million isn't enough... There's probably much bigger problems that the SWR

.

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nuke_diver · Mar 10, 2015

One of the reasons I like FRP is because you can play out these kinds of "future" scenarios. While a simulation and a MC one at that I will do things like see what say a 50% drop would do(followed by only normal conditions not a sharp recovery). If it shows bad things then I can model what a change in spending would do. This is a likely reaction to a bad year for most people, cut your expenses if you are not sure (no long distance travel no new car etc) and see what it takes to get to a high likelihood of success.

It's a fun game. The scenarios that fail completely are my zombie apocalypse ones...but then we are all doomed anyways so I'll be no more doomed than anyone else and at least would have had a few years of freedom before the end of the world

daylatedollarshort · Mar 10, 2015

Just some food for thought on stock and bond alternatives for the risk averse, using TIPS and annuities instead:

"In today’s financial markets, an investor can invest $100,000 in TIPs and annuities to fund an annual inflation-adjusted payout of about $4,700 starting at age 65. The specific implementation would require an $85,000 outlay to TIPs and $15,000 to a deferred annuity. - See more at: Low-Risk Investments Can Protect Retirement Payouts | Texas Enterprise"

Cobra9777 · Mar 10, 2015

Psychological Hedging

My approach to this was to simply minimize reliance on withdrawals altogether. We paid off the mortgage and elected the annuity option on both our pensions. We also bought some income-producing real estate with money that had previously been in the bond allocation. Our investable portfolio is a lot smaller after these actions, but we have 70% of expenses covered by guaranteed income (mostly COLA'd, and pre-SS). Cash distributions from the taxable account cover about half the remaining gap. And we carry a cash balance to fund several years of the other half. I've been questioning the value of that cash balance lately, and will probably reduce it. But our situation is fundamentally different than those carrying a big mortgage with no pension/SS.

This approach is not without its costs. Taxes are pretty high with pensions and rentals, which leaves very little room for Roth conversions, and no chance for ACA subsidies. I'll also never experience the joy of watching my portfolio outperform the mortgage. But I don't need a lot of cash lying around, and in the next meltdown, I won't be the one posting, "Holy cr@p, the sky is falling..."

audreyh1 · Mar 10, 2015

Good overview posts!

I like our % of remaining portfolio WR method because we don't take a raise unless the market gives us a raise. And we have to take a cut if the market makes our portfolio shrink. We're not keeping up with some inflation adjusted amount that was determined by the initial portfolio and taking out more than the prior year even though our portfolio is down 25%.

You have to be willing to be flexible in terms of annual income.

Moemg · Mar 10, 2015

Thanks for the walk down memory lane . I was shocked that I was not whining in more posts . I retired in Jan. 2008 and proceeded to lose almost 40% of my stash .I do the 4% of portfolio withdrawal so I got a budget cut . It worked out fine since I recovered but my nerve to spend has not recovered . I am too conservative now . My daughter will be happy but I need the nerve to spend back before I am too old ..

petershk · Mar 10, 2015

Moering: I'm impressed by your steel nerves. Seems youre prepared for most everything

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haha · Mar 10, 2015

urn2bfree said:
*the reason I reference the highest value your portfolio reached rather than the value the day you actually start withdrawing is that the SWR "works" for those who start withdrawing money at the peak, so how could it not work if you don't start at the peak and therefore have a zero withdrawal that peak year.

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Gee Boss, sounds great!

Ha

A Walk Down Memory Lane... or... Psychological Hedging

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